Europe’s energy crisis will be a persistent economic obstacle

Europe’s dependence on Russian gas has steadily increased over recent decades despite massive investment in renewable energy. In fact, the share of Europe’s gas coming from Russia has increased from 26% in 2001 to 37% in 2019. Today, with the war in Ukraine, Russia is using this dependence to try to undermine Europe’s support for Ukraine and push for sanctions relief.

Graph 1: European reference price for TTF gas

(EUR per MWh)

Source: Bloomberg

Due to dependence on Russian gas, prices have risen across the continent. In fact, the benchmark gas price for the TTF in Europe has increased by almost 8 times the average since 2010 (Figure 1). However, the pressure is not the same across the continent, with the northern, central and eastern European countries generally most dependent on Russian gas (map).

Gas plays an important role in the European economy for heating homes, for heavy industry and as a marginal fuel in electricity generation. Therefore, these record prices are already acting as a headwind for the European economy. But with the war in Ukraine far from over, financial markets have decided to expect continued high gas prices in 2023 and 2024. This week we examine the implications of this for the outlook. Europe’s economies, focusing on four main channels: impact on consumer demand, industrial production, monetary policy and fiscal policy.

Map: Share of natural gas imports from Russia

(%, 2020)

First, consumer demand is already affected by high energy prices, capacity constraints and tight labor markets. Consumer confidence has deteriorated sharply and has fallen further since May as utility bills are expected to double in many countries. Similarly, prices for holidays, restaurants and other services have risen sharply due to capacity constraints at airports and hotels, which have been unable to recruit enough staff despite significant wage increases. Overall, high prices for energy, services and goods are a significant impediment to consumer demand across Europe, despite the high levels of savings of some wealthy households.

Second, record high gas prices have already caused large gas-using companies to reduce their consumption by a good 10%. Going further, in response to Russia’s reduction of gas flows, the EU has negotiated a target to reduce global gas consumption by 15% by 2022. However, if Russia completely cuts off its gas supplies, that may not be enough. Goldman Sachs estimates that a shutdown of Russian gas flow through the Nord Stream pipeline would reduce GDP by 3.5% in the euro area, 3.7% in Germany, 5.6% in Italy and 1.5% in France. Considering that flows are already reduced to only 20% of their capacity, we can conclude that GDP will already be strongly affected by the fall in industrial production in Europe.

Third, we examine the impact on monetary policy. The European Central Bank (ECB) and the Bank of England (BoE) are lagging behind the aggressive series of rate hikes carried out by the US Federal Reserve (Fed). This is already putting downward pressure on the euro and the pound, which has weakened against the dollar. Weak currencies add to inflationary pressures, not to mention that European inflation is more sensitive to energy prices, which are also higher in Europe than in the US. It will therefore be very difficult for the ECB or the BoE to avoid raising interest rates significantly despite the very concrete prospect of a sharp slowdown in GDP growth.

Finally, fiscal policy cannot come to the rescue for two reasons. First, compared to the pre-pandemic period, governments have higher deficits and debt levels, limiting fiscal space. Second, governments cannot provide blanket support to all businesses and households without increasing energy demand and inflation. Therefore, fiscal support should be limited and targeted with direct payments to the most vulnerable businesses and households.

In conclusion, weakening consumer demand, limited industrial production, tight monetary policy and limited fiscal support mean that European economies face several important headwinds. These headwinds are all caused or exacerbated by high energy prices and/or limited gas imports from Russia due to the war in Ukraine. The war looks increasingly likely to drag on into 2023, meaning a recession in Europe is now more likely than not, and inflation is likely to remain persistently high next year.

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